Question

Consider a one-year investment that has the same risk as a firm’s existing assets. The investments require $1 million immediately and has an expected IRR of 8%. The firm is considering debt financing for the $1 million with a bond with a 5% coupon paid at the end of the year. The firm’s existing debt is riskless with a yield to maturity of 5%. If the firm goes ahead, it will maintain its target debt/equity ratio of 25% and K_d and K_e of 5% and 10%, respectively. The firm has 1 million shares outstanding (assume there are no taxes).

1. If the project is accepted and financed with the bond, what is the expected effect on the firm’s EPS at the end of the year? (provide dollar figure)
2. If the project is accepted, what is the expected effect on the value of the firm and on the firm’s equity value? (provide dollar figure)

Answer 1

The IRR of the investment is 8%. The current cash outflow is $1mn.

The investment is for one year as is given in the question. So the only cash flow from the investment will occur in one year's time.

IRR is the rate that makes NPV zero. Using this we can calculate the cash flow that will result in one year from the investment. Let the cash flow be x.

Hence,

x/1.08 - $1mn = 0

x/1.08 = $1mn

Hence x = $1.08mn

Profit from the investment comes to $.08 mn i.e. $80,000.

Now let us calculate the cost of new debt that we have raised for the investment.

It is a $1mn bond with coupon rate 5%.

Cost = $50,000.

So net profit from the investment would be $80,000 - $50,000 =$30,000.

a. Hence earnings will increase by $30,000.

Hence the increase in EPS can be calculated as follows:

=increase in earnings/total number of shares outstanding

=30000/1000000

=$0.03

Hence there will be an INCREASE in EPS by $0.03

b. Value of firm is the total value of firm's debt and equity.

If the projected is accepted the firm's debt will increase by $1mn.

Hence, the value of firm will also increase by the same amount.

But there will be no impact on firm's equity as no additional equity is raised and the investment is entirely debt financed. Only the earnings to the equity shareholders will increase as in part a.